Management of risk is fundamental to the business of banking and is an essential part of a bank's economic strategy. Banks face various risks and the success of a bank's operations relies on its ability to optimize the rates of return for the capital available to the bank based on pre-determined risk management constraints.
In the normal course of banking operations, a bank's earnings depend on, among other things, the difference in interest rates between that which the bank collects from its activa products (a product is the aggregate of similar accounts, i.e.--all residential loan accounts with an interest rate of 10% might collectively be referred to as a single loan product, or likewise for loans having similar risk characteristics) and that paid by the bank via the passiva products it uses to finance the activa products. As defined in the text "Economic Terminology" by authors Renner and Sachs, which is incorporated by reference herein, "activa" is equivalent to the term `loan function`, and "passiva" is equivalent to the term `deposit function`. Additionally, the use of the term "financing" is used to describe the activity of a bank in using deposit functions to sell loan functions.
Ideally, a bank would simply allocate the capital from its lowest interest passiva product (i.e.--savings accounts, or the like, for which the bank pays the customer, for example, 1% interest) to finance its highest interest activa product (i.e.--loan accounts, or the like, for which the bank collects, for example, 10% interest). In this situation, the bank would make the most profit because the interest collected by the bank would maximally exceed the interest paid. However, this method is not typically possible because of risk management constraints imposed upon the bank. These risk management constraints require the bank to use capital in such a way as to minimize (or at least lessen to acceptable levels) the risks to the capital.
For instance, a bank takes a risk when providing a loan that the customer receiving it will default on the loan. If such a default takes place, the funds used to finance that loan is lost or may only be partially recoverable. Since the funds used to finance that loan originated as capital in the passiva accounts belonging presumably to other customers of the bank, a default may adversely affect the passiva account holder. In order to protect against this situation, both a governmental entity and/or the bank's management can impose constraints on the way in which the bank can finance the loans it makes. Typically, the constraints state which passiva products, and what percentage of each passiva product, can be used to finance each activa product. In this manner, an activa product can be financed by the capital from a number of different passiva products, and the percentage of the activa product which may permissibly be financed by each of the passiva products is pre-determined. Extending the example of the previous paragraph, risk management constraints may permit i.e.--only 25% of the 10% interest rate loans to be financed by the 1% interest rate savings accounts, thus minimizing the risk to the capital in the 1% savings accounts.
These pre-determined limits potentially conflict with the bank's profit-maximizing objective. The bank can not automatically finance its highest interest-paying activa products with its lowest interest-bearing passiva products. In order to operate optimally, however, a bank must utilize a method which enables it to maximize its profit while staying within the risk management constraints imposed upon it.
Therefore, there exists a need for a method which ensures that a bank finances its activa products with capital from passiva products so as to maximize profits while still operating within any imposed risk management constraints.